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Gilt issues

I spent last week gazing out over the North Sea, counting the ships in and out of Felixstowe Docks. That there are fewer of them is clear. World trade has been strangled by the double whammy of poorer consumers in the West and a lack of credit to finance inventories. It appears to be rapid de-stocking that has caused the very sharp downturn in global economic activity.

The other side of this is that any pick-up could produce shortages and add to inflationary pressures. Inflation was on everyone’s mind last week. With RPI forecast to deliver a negative number, the fact it was unchanged over the year came as a surprise. Add to that the rise in CPI, provoking yet another letter from the governor of the Bank of England, and a rise in underlying inflation and it is clear a rising cost of living remains in prospect.

This spooked markets just a little, although it was the failure of the gilt auction which caused the greatest concern. The level of Government indebtedness on both sides of the Atlantic will limit the action that can be taken and remains a problem for which a solution has yet to be found. In the meantime, it will also act as a constraint on demand for new issuance.

All this confirms my belief that holding gilts could prove to be a risky exercise. Most issues contain a guarantee of capital loss if held to redemption – a loss, I might add, that cannot be used to set against gains made elsewhere. The income returns are miserly and the only real argument is that they will prove a safe haven if a prolonged recession, or even a depression, takes hold.

So, where does the wily investor commit cash these days? Talking to a typical member of the investing classes in Suffolk last week (retired, cash-rich but income-poor), it became clear the attractive options had all but vanished. Basic bank deposits provided little return, although a one-year fixed deposit had been secured to yield 3.9 per cent. But such was the degree of caution exercised by this careful lady that she would only entrust £50,000 to a single bank.

Bonds – or to be more precise, corporate bond funds – were favoured, not just for their higher income but also because a perception had been gained that they were mispriced and offered the chance of a capital gain. This worried me a little. I have bought into the corporate bond argument – and one of the brightest investors I know has seen value there too – but when wealthy widows start jumping on board I sense a bubble.

The risks are twofold. If the downturn is more severe or longer – or both – than we fear there will be more defaults, justifying the poor valuations these bonds have at present. If the price of quantitative easing is a return to inflationary conditions, then fixed-income investments will suffer accordingly. Perhaps worse of all would be stagflation. But none of this may come to pass.

Even so, corporate bond funds are not without risk. I plan to stick with mine, but at the first sign of sustained inflationary pressures I will be seeking pastures new.

They are not a substitute for equities and should always be viewed as just one component of a broad asset mix.

Brian Tora (brian.tora@centaur.co.uk) is principal of the Tora Partnership

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